True Investment Diversification in Detail

I’ve said many times that people believe they have diversified portfolios when they really don’t. Here’s a good explanation of what true diversification is and its benefits. It explains how diversification can result in higher long-term returns and also less risk in the portfolio, with risk being measured as the variability of returns.

When we examine the full three-year experience of a diversified investor relative to investors with concentrated investments in just one market, it’s clear that diversification produces a gentler ride. While the diversified portfolio produced the same return, it did so with about 1/3 less volatility. Even better, because the declines in the two markets occurred at different times, the diversified portfolio achieved its returns with a 40% smaller peak-to-trough loss than that endured by investors in either of the individual markets.

However, while it’s clear with the benefit of perfect hindsight that diversified investors were better off over the entire period, it’s illustrative to revisit how each investor might have felt half-way through. At that time, investors who chose to diversify were probably regretting their decision, as Market 1 had produced about 25% in extra returns. They were wishing that they had never even heard of Market 2! Only after the completion of the period, once Market 1 experienced its own 26% decline, would diversified investors finally have felt vindicated.